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06/20/2006

Privatizing the Nation's Highways--and Other Infrastructure--Posner

The State of Indiana has just leased the Indiana Toll Road--a 157-mile-long highway in northern Indiana that connects Illinois to Ohio--to a Spanish-Australian consortium for 75 years for $3.8 billion, to be paid in a lump sum. (The deal has been challenged in the Indiana state courts.) The lease is complex, imposing many duties on the lessee (such as to install electronic toll collection, in which Indiana has lagged). A key provision is that the consortium will not be able to raise toll rates until 2016 (for passenger cars--2010 for trucks) and then only by the greatest of 2 percent a year, the consumer inflation rate (CPI), or the annual increase in GDP. (On the eve of the lease, Indiana raised toll rates--which hadn't changed since 1985--significantly.) Two years ago Chicago made a similar lease of the Chicago Skyway, an 8-mile stretch that connects Chicago to the Indiana Toll Road, for $1.8 billion. There is considerable interest in other states as well in leasing toll roads to private entities.
The idea of privatizing toll roads is an attractive one from an economic standpoint. Private companies are more efficient than public ones, at least in the limited sense of economizing on costs. I call this sense of efficiency "limited" because there are other dimensions of efficiency, for example the allocative; a monopolist might be very effective in limiting his costs, but by charging a monopoly price he would distort the allocation of resources. Some of his customers would be induced by the high price to switch to substitutes that cost more to make than the monopolist‚Äôs product but that, being priced at the competitive rather than the monopoly price, seemed cheaper to consumers. (This is the standard economic objection to monopoly.) The reason for the superior ability of private companies to control costs is that they have both a strong financial incentive and also competitive pressure to do so--factors that operate weakly or not all in the case of public agencies--and that their pricing and purchasing decisions, including decisions regarding wages and labor relations, are not distorted by political pressures and corruption. There is a long history of price-fixing in highway construction and maintenance, attributable in part to bidding rules that, in endeavoring to prevent corruption, facilitate bid rigging. For example, if to prevent corruption contracts are always awarded to the low bidder, a bid-rigging conspiracy will always know whether one of its members is cheating, if the low bidder, who gets the contract, was not the bidder that the conspiracy assigned to make the low bid. If cheating on a conspiracy is readily detectable, cheating is less likely and therefore the conspiracy more effective.
The problem of allocative efficiency looms when, for example, there are exernalities; but the solution to the problem rarely requires public ownership. One significant externality associated with vehicular transportation is the congestion externality: no driver is likely to consider the effect of his driving on the convenience of other drivers, because there is no way in which he can exact compensation from drivers for not driving or driving less and therefore improving their driving time. That externality is internalized by a toll road, because congestion reduces the quality of the driving experience and so the amount each driver is willing to pay in tolls; the owner of the toll road will trade that willingess to pay off against the reduction in the number of drivers as a result of a higher toll.
Another externality, however, will not be internalized by the toll-road operators. That is the contribution that driving makes to pollution and global warming. But public ownership is not necessary in order to internalize this externality. The government can force its internalizing by imposing a tax on driving.
There is, however, in the toll-road setting another source of allocative inefficiency, and that is monopoly, which I have mentioned already. Drivers who do not have good alternatives to using the Indiana Toll Road can be made to pay tolls that exceed wear and tear, congestion effects, social costs of pollution, and other costs of the road, engendering inefficient substitutions by drivers unwilling to pay those tolls. To an extent, the toll-road operator may be able to discourage substitution by price discrimination, but this is unlikely to be fully effective and indeed can actually increase the allocative inefficiency of the monopoly.
The monopoly issue raises the question: what exactly was Indiana selling when it leased the toll road for $3.8 billion? The higher the tolls and the greater the lessee's freedom to raise the tolls in the future, the higher the price that the state can command for the lease. If the lease placed no limitations on tolls, the state would be selling an unregulated monopoly. If the lease could constrain the lessee to charge tolls just equal to the cost of operating the toll road (including maintenance, repairs, snow removal, lighting, and the collection of the tolls), the market price of the lease would be significantly lower. To the extent that the state wants to maximize its take from the lease, it will be creating allocative inefficiency by conferring monopoly power on the lessee.
It is difficult to determine whether the $3.8 billion price tag for the Indiana Toll Road is closer to the competitive or the monopoly price level. On the one hand, the lessee cannot raise tolls until 2010 or 2016 (depending on the type of vehicle), and increases after that are capped. On the other hand, the tolls were raised significantly just before the lease, and allowing the operator in 2010 to begin raising toll rates annually by the increase in GDP may confer windfall gains, since the cost of operating the toll road may not increase at so great a rate. One would have to know a great deal more about the economics of operating a highway than I do to figure out whether the terms of the lease confer monopoly power on the lessee.
I do not regard the monopoly concern as a strong objection to the leasing of the toll road, however. The reason is that most, maybe all, taxes have monopoly-like effects, in the sense of driving a wedge between cost and price. Suppose the lease price would have been only $2 billion had the state imposed more stringent limitations on toll increases. Then the state would have $1.8 billion less in revenue and would presumably make up the difference by increasing tax rates or imposing additional taxes, and these measures would have allocative effects similar to those of higher tolls charged by the lessee of the toll road. If the monopoly issue is therefore considered a wash, the principal effect of the lease will be the positive one of reducing the quality-adjusted cost of operating the toll road and the lease is clearly a good idea.
Toll roads are more attractive candidates for privatization than non-toll roads because it is easy to charge user fees; tolls are user fees. It would be harder to charge for the use of city streets, though no longer impossible, given electronic technology for monitoring drivers. Privatizing certain security services pose special problems as well, as Becker and I discussed in our May 28 posts about security contractors in Iraq. But public services the cost of which is defrayed in whole or significant part by user fees are good candidates for privatization, including Amtrak, the Postal Service, building and restaurant inspections, veterans' hospitals, and federal, state, and local airports. The privatization movement has a long way to go before achieving an optimal mixture of public and private service providers.
Against all this it will be argued--it is an argument emphasized by opponents of leasing the Indiana Toll Road--that privatization, at least when it takes the form of a sale or long-term lease of government property for a lump sum, beggars the future by depriving government of an income-producing asset. The argument, at least in its simplest form, is unsound, because the state is not disposing of an asset but merely changing its form: from a highway to cash. The subtler form of the argument is that, given the truncated horizons of elected officials, the state will not invest the cash wisely for the long term, but will squander it on short-term projects. This is a danger--how great a one I do not know. It would be an interesting study to trace the uses to which privatizing governments here and abroad have put the proceeds of sales of public assets.

Comments

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A performance rating system is needed to evaluate performance of public-private sector partnerships including long-term leases of public property or built to operate projects. Firms like Moody's or S&P could provide such a service on a pro bono basis for countries worldwide.

I do not pretend to know about the intricacies of the case in question, but suspect that you're right to express concern over the short-term goals of elected officials when measured against the long-term needs of the state. Would a simple solution to this danger not be to require the lessee to make (and the state to accept) a fixed number of payments over the term of the contract. These could even conform to the specific political cycle in question. This would, of course, not stop politicians from sqaundering the cash. It would, however, ensure that they sqaundered it on an even basis over the term of the lease.

In both the Chicago Skyway and Indiana toll road leases--as I understand them--the lease payments (lump sums) have been earmarked for debt reduction and funding of other highway projects.

On the evidence, the winning bidder clearly overpaid. The state's own (privately contracted) auditors put the net present value of the 75 year's toll 'profit', at less than about $1.9 billion.

In addition to the $3.85 million lease payment to Indiana, they committed to another $4.4 billion for maintenance, repair and expansion. However, I see that there is the ability to raise tolls by the same percentage that GDP rises, which at least gives the operator some hope of recovering its investment.

Further, they might be able to expand revenue by squeezing the service providers along the turnpike, be expanding capacity, and by advertising along the route.

The next prize for this consortium is obviously the Ohio Turnpike. I'm guessing they overpaid for Indiana and Chicago's roads thinking they are the first step in assembling a network of toll roads. But, they ought to read Stan Liebowitz's 'Re-Thinking the Network Economy', because it's unlikely there's any kind of 'first mover advantage' to capitalize on here.

This is not the first time that the country has had a "privatized" transportation network. First, were the private canal systems and then the old private "plank roads" and ferry crossings. All superceded by the State Highway system, U.S. Route System and finally the Interstate System. As for Indiana's lease, they as lessor are at least still maintaning posession as owner. One concern, is who has responsibility for ongoing maintenance and repairs of the highway and associated elements? These things require large amounts of repair work during the year to keep them operational and safe.

Yet, there is a dark and sinister side to this picture. That is, why did the State find it necessary to lease out a portion of the public estate in the first place? Is there a particuliar problem with the budgeting that requires a multi-million dollar cash influx in the first place. Could it be do to the tax cuts across the board that has placed the State in financial jeopardy? Or is it due to the collapse of the industrial and business base that many States are experiencing and related loss of revenue due to lost payroll taxes and corporate taxes?

On another note, are we about too see Congress create a concession for the Mall in D.C. and lease it to perhaps the likes of Al-Qaeda or maybe Disney? This is just another little concern that one has to take into account when privatizing the Public Estate.

It would be good to privatize Amtrak railway tracks and use the proceeds to fund long-term renewal of high speed trains linking Central Indiana to Chicago, upgrading Boston-New York-Washington D.C. and other natural high volume transportation corridors in California, Florida and Texas.

In Indiana, only about $200 Million is being used to pay down debt, and that debt is only the debt still outstanding on the Toll Road bonds. The rest of the money is going to a colossal road-building project, basically, described as jump-starting the economy of the state.

The question of paying down the debt was an issue in the litigation, since the state Constitution (Article X, Section 2) provides essentially that the surplus revenue derived from any asset of the state (whether sold or leased) should be applied against the "Public Debt." The Supreme Court conceded that the "Public Debt" in the "lay sense" of the term included the debt of the Indiana Finance Authority, for example ($2.5 Billion in outstanding bonds). However, the Court reasoned that the Public Debt could only mean the State Debt in existence in 1851, all of which was paid off in the 19th Century. Ergo, this provision of the Constitution had become a complete anachronism over 100 years ago, although 100 legislative sessions had come and gone with no one noticing that Article X, Section 2 should simply be repealed.

An examination of the decision in Bonney v. Indiana Finance Authority will allow one to draw one's own conclusion as to whether the Court's reasoning is persuasive.

As to the $1.9 Billion estimate of the NPV of the Toll Road, that estimate was made by a firm which has a long relationship with state government, and was made after the decision had already been made to accept the $3.8 Billion bid. This valuation was dumped on the legislature a few days before the final vote as a way to sway reluctant legislators. As far as I can tell, Indiana never had an appraisal of the value of the road performed before the bidding process. This is mind-boggling, since I would not even sell my house on the open market without having it appraised first.

All of the public documents are posted at the Indiana Finance Authority's website.

What seems to be missing from both analyses is the issue of quality of service/maintenance by a monopolist. In the case of public roads, lower maintenance standards may be a major source of 'economizing on costs' - and a major concern in terms of both public safety and the future of a lucrative asset; both of these concerns represent externalities that are not discussed by either Posner or Becker. Contractual provisions that set minimum spending requirements on maintenance are a crude proxy, at best, to setting a qualitative standard for maintenance, and are extremely hard (i.e. costly) to enforce. Government monitoring of maintenance standards undermines much of the idea of privatization, is similarly hard to enforce, and poses risks of agency capture and other well-documented phenomena.
These obstacles may all be overcome if a reasonable substitute is available, eroding much of the monopolistic power of the leased road. However, if - as Becker suggests - we are to rely on dynamic assumptions regarding the possibility that a competing highway would be built from scratch, the idea of privatization seems much more dubious. The main reason for this skepticism is that monopoly prices would only attract competitors who expect to be at least as efficient as the encumbent monopolist (if not - they would be driven out of the market by the monopolist after entry). In the case of highways, the monopolist presumably controls the 'best' route, assuming the initial planners did a decent job and that subsequent land developers have utilized the existing route in their planning; state regulatory regimes would generally not allow a new route to be merely duplicative; any putative competitor would have to rely heavily on the state's willingness to slaughter its own 'golden goose', since highway-building is perhaps the quintessential activity calling for use of the state's eminent domain powers; and finally, the monopolist, being a lessee, had not incurred any of the sunk costs associated with the initial building of the leased highway, and thus may operate it at a profit at the marginal, instead of average, price. Under these circumstances, the monopoly in roads is as close to being unassailable as can be - again, making the whole privatization enterprize much more problematic than either Posner or Becker suggest.

The privatization of roads has traditionally been one of the mostly successful privatization initiatives ñ at least internationally. For years private concession have managed highways in Europe and Latin America. The returns are not huge, the economics are understood and the regulation works. This is not the area where we should be having a privatization debate ñ the other brought up by you both seem more important and interesting. I feel we would not have heard about it if it where not for the US being and election year and Indiana a red state etcÖ.

Iím shocked that so many people,

http://psdblog.worldbank.org/psdblog/2006/06/privatizing_roa.html ,

have jumped onto this? I donít remember the same debate when Virginia and Illinois did similar project earlier last year.

Although it's not strictly connected to privatization, I'm surprised neither of you mentioned the deadweight loss that results from the hundreds of thousands of man-hours drivers spend sitting at toll plazas every year, not to mention the extra pollution these delays generate. I'm sure with advances in EZ pass technology these costs can be reduced, perhaps dramatically, but until they are, can it possibly be more efficient to fund highways through a toll system, whether privately or publicly administered, than through general taxation?

Two observations: is it me or did the winning bidder apparently overpay for the right to take over control of the toll road?
Second, privatizing a monopoly is nonetheless wrong on principle even assuming the best-case scenario, i.e., a cash windfall for the State of Indiana coupled with a a potentially better-run toll road by the winning bidder.
We give to government, among other things, the right to the exclusive control over certain limited areas of our lives. Generally speaking, if that control involves an "essential" government service then that service cannot be delegated or transferred. Here, that was obviously not the case and the State of Indiana earned a large windfall as a result. However, monopolies of non-essential services are as wrong in the private sector as they would be in the public sector given the noncompetitveness associated with them. Perhaps the answer lies in demanding that government be limited which would, among other things, prevent it from having the right to monopoloze non-essential services in the first place either for itself or for others (in which case the State of Indiana would not have had anything to sell). As a result, there would not be various entities, roaming Washington and various state capitols while flush with cash and influence, looking for monopolistic alternatives to the marketplace. They would not be there simply because government would not be in a position to give them what they wanted.

'As far as I can tell, Indiana never had an appraisal of the value of the road performed before the bidding process. This is mind-boggling, since I would not even sell my house on the open market without having it appraised first.'

It would be mind-boggling, but it doesn't seem likely to be true. Indiana hired Goldman Sachs as its adviser, and Goldman had done Chicago's deal earlier. Chicago was very pleasantly surprised to get as much as they did.

Mitch Daniels was publicly tossing around the $ 2 billion figure long before they actually got any bids. Peter Samuels of Toll Road News says he's got good sources that there were two bids in the $2.2-2.5 billion neighborhood.

And, as someone else noted, there is plenty of experience for comparison.

One thing I think Cintra-Macquarie may be underestimating are the political realities. California had a lease agreement with a private construction company to first build and then operate some toll lanes in the median of existing SR 91 in Orange County.

They did a beautiful job, even offering people their money back if they didn't get an uninterupted trip. Which they accomplished by changing the toll amount every six minutes to control demand.

But, the state eventually bought back the rights they'd sold, because enough whiny special interests managed to poison the politics.

Same thing happened to the private investment group that built NYC's first subway in 1904. They had a 50 year lease with an option to extend it to 75. But, they ended up turning it over to the city in 1940, thanks to the efforts of, among others, Wm. Randolph Hearst.

A more general issue is that privatization saps the quality of government employees if the more ambitious can quit and go into identical jobs in the profit-making sector. We're paying the price in Iraq where our best $30,000 per year sergeants are quitting the Army and returning as $150,000 per year Blackwater mercenaries. The taxpayer is out $120,000, and the Army, which does the real fighting, loses its best men.

If you look at the high quality of government work from, say, the New Deal through Apollo 11, compared to the low effectiveness of government undertakings in recent years, you'll see evidence that privatization is undermining government effectiveness.

First, privatization doesn't reduce quality of government workers. In theory, privatizing a project should eliminate the government jobs devoted to it, thus freeing those working on it to take private sector jobs doing the same thing. In practice, of course, it's impossible to get either party to reduce the size of the government, so privatization will make a difference in that regard. That's not a knock on privatization, it's a knock on the people we put into office. If we did privatization right and eliminated the government jobs that are no longer necessary after a project has been privatized, quality people would be doing the work, they'd just be paid private sector money rather than a government pittance financed by the taxpayer.

Second, if a sargeant in a combat zone that is supposedly a vital front in the war on terror, which is supposedly a national goal, is making $30,000 a year, maybe we should up their pay rather than complain that the taxpayer "loses out" when able people flee to the private sector. If we want quality in government positions, we'll have to pay for them. (And elect them.) If the war on terror is so important to us, we should pay the best to fight it rather than hope that someone else is patriotic enough to risk their life for $30,000. If we want effective government, we should be willing to pay government employees enough to lure them away from the private sector. You get what you pay for, and that's exactly what we've been getting.

Just so I don't get attacked for saying mutually contradictory things: if we want quality people in government positions, we must raise government salaries (and fix a few other things wrong with the political process), which would obviously cost more in taxes. If, however, we pair this with privatization of projects and eliminate the corresponding government jobs, there will be fewer high-paying government positions to fund. I don't know what the net effect of this on government spending would be, but I just want to clarify that my positions are consistent with each other.

Posner talks about the monopoly problem, but doesn't say why the problem is worth a mention. Doesn't the problem disappear if state government permits construction of alternate toll routes i.e. allows entry? Unless there is some provision in the contract that prevents entry, it is hard to see why the monopoly problem should be of special concern here.

Harris, I've got a better idea, why don't we just lease everything to the Chinese and N. Koreans and let them operate based on the "Coolie Principle". At least we'll get incredible labor cost efficiencies. ;)

I'm from Gary Indiana, and basically think the deal was fine for Indiana. The reason for the opposition seemed to be that people didn't like the thought of selling off the state's assets to "non-Hoosiers" who were "foreigners" to boot -- which is clearly not a legitimate reason for opposition.

There are at least, however, two potential problems which have been mentioned. The first is the danger that Indiana will use the money on a bunch of stellar road projects now which are now needed much less than increased funding in health care and education for economic development. The second is that the great fudge factor in this deal is the $4.4 billion in promised service and repairs. The consortium will have huge incentive to cheat (and hide their true gains from the public), and will also have huge incentive to use a big portion of this money to throw their weight around in the capital to ensure they don't get caught cheating. We should mitigate this against the public's general outrage over "carving up the state's assets and handing them over to foreigners", which will ensure that any bad service, at least in the interim, is likely to be duly noted in papers and at election time.

Indiana Gov. Mitch Daniels will most likely pay for his own tone-deafness on the lease w/ his job... Which means the evil democrats will take charge and spend the money on education rather than on new highways in a state w/ stagnant pop. growth... In the future as well, politicians will always have huge incentive to grease this sensitive issue for all its worth, which is the only reason we have to doubt the consortium might not be getting their money's worth. Think of what happens when oil companies make billion-dollar investments in places like Bolivia...

The key is that, in any complicated deal like this, one can find holes. The prettiest part is that these holes are sure to be exploited by the Dems in Indiana for the next 75 years.

Taisha, I think Cintra-Macquarie would be foolish to cheat on repairs and maintenance. It would be obvious after 10-15 years if they weren't fulfilling their obligations, and they'd be in default and in danger of losing everything.

Further, this is going to be a publically traded investment (maybe even a mutual fund) so the spending is going to be open to everyone's view.

As for them having a lot of money to throw around, they're up to their eyebrows in debt in this thing. They've borrowed 80% of the first $4 billion from banks. At a prime rate of 8% they've got interest alone of over $250 million annually to pay. To which add another $80 million per year in capital expense they've committed to (over $400 million in the first five years). Then there's their operating expenses.

In their first five years they're going to have an outflow of cash of about $2 billion. They're projecting revenues of about $ 700 million for the same period. They'll be lucky to survive the early years.

As for the Dems spending the money elsewhere, Daniels has committed most of it already to highway projects. It's gone within 10 years.

There are two relatively new privatization initiatives underway in Illinois: one, the privatization of the Illinois Lottery (again, a lease, not an outright sale), was floated a few weeks ago as a way for the State to inject $10 billion into education. There were immmediately doubts raised about this figure--another Goldman estimate, I believe.

On the + side, it is thought that a private company would have more ability and incentive than the State to increase lottery sales through more creative games and marketing, and therefore the NPV to the State of leasing the lottery is greater than if it continues to operate it itself.

The (R) candidate for Governor immediately raised the point about "selling off the State's assets" (note that there is no pattern to the politics of government asset sales).

The lottery qualifies as a regulated monopoly, I think, as long as the State does not allow free competition in gambling. It is likely that if such a sale occurred, there would be strict controls on the amount of sales that must be paid out in prizes (therefore limiting the monopolistic profits just as in the case of the Indiana Toll Road).

The second, more probable privatization involves four large underground parking garages owned by the City of Chicago. They are located below Grant Park on the City's lakefront, adjacent to the Loop. The garages comprise approximately 9000 spaces in total, making this the largest potential parking privatization in the U.S. The City intends to use the proceeds of the sale (again, really a long-term lease) for other capital projects. That is also what they are doing with the Skyway proceeds that were not used for debt retirement; but they are clear that this will be a policy decision and they reserve the right to use some of the monies for operating purposes.

One argument against privatization I have not seen raised here is the real net loss of jobs (never mind whether the new jobs pay more or less than the old jobs). As one who is in the outsourcing business, I can attest that many an attempt at "good" privatization--meaning a non-core function for which there is an existing competitive market--gets stalled out over this issue before it leaves the gate.

Even if the government allowed entry, the monopoly would probably remain in place. The current road was probably placed in the best possible place, and if it wasn't, that is certainly the best place for it now that new construction was done with that road in mind. Other toll roads would have to be in less efficient locations, and thus would not be competitive.
Even if other locations were available, such building would by definition be duplicative. It would be the same if each electric, cable, or power companies had to lay their own cables to one's house. Doing that would be economic waste. Hence, true competition isn't prevented by regulation (I mean, regulations hurts, but it's fixable) but by the natural monopoly nature of this particular road. The circumstances, as I have said before, would be different in a big city, for example.

'Can states make money by building more highways and then selling them to the highest bidder at a cost higher than what it cost to build?'

Yes, but a better model is simply allowing private entities to build and operate them under a franchise agreement.

It's been done many times, but the politics becomes poisonous in the end. It happened to August Belmont after he'd built the IRT subway in NYC in 1904. It recently happened in Orange County, Cal. with the toll lanes of SR-71.

Interestingly, in Europe they seem to be more realistic about the economics:

Under the lease/Act, as I understand it, the state has agreed not to upgrade the only roads which could arguably compete with the tollway. These are Routes 20 and 120 which run roughly parallel to the tollway, but are generally narrow unimproved routes. So the state has in fact given the tollway operators a monopoly on Chicago to Ohio traffic.